Wall Street has long been a profitable investment avenue, consistently outperforming other asset classes such as commodities, housing, and bonds. However, when examined over shorter periods, the stock market becomes highly unpredictable. As a result, investors are turning to various economic indicators to gain insight into the future direction of major stock indexes like the Dow Jones, S&P 500, and Nasdaq Composite.
One such indicator that is currently making waves on Wall Street is the U.S. money supply. This is a historic occurrence, as it hasn’t happened since 1933 and could potentially signal a significant move for stocks. The U.S. money supply has different measurements, with M1 and M2 being the most popular. M1 includes cash, coins, and easily accessible cash like traveler’s checks and demand deposits. On the other hand, M2 encompasses everything in M1 plus money market accounts, savings accounts, and certificates of deposit under $100,000.
What’s catching attention is the decline in M2 money supply over the past 15 months. While small decreases have occurred in the past, there have only been five instances where M2 has significantly declined by at least 2% on a year-over-year basis. Four of these instances happened in the late 1800s and early 1900s, while the fifth is currently ongoing. This decline has economic implications, as it indicates less capital in circulation, potentially leading to a downturn in the U.S. economy.
Furthermore, the previous notable drops in M2 led to deflationary depressions with high unemployment rates. However, it’s worth noting that the likelihood of a depression with double-digit unemployment is much lower today due to the Federal Reserve’s better understanding of monetary tools. Nevertheless, a significant decline in U.S. money supply cannot be ignored, and if a recession were to occur, history suggests that stocks could experience considerable declines in the short term.
Another indicator that is sounding a warning for Wall Street is U.S. commercial bank credit. Similar to M2, commercial bank credit has been steadily increasing over the past 50 years due to economic growth and increased lending. However, there has been a marked drop in commercial bank lending since reaching an all-time high in mid-February 2023. This decline in commercial bank credit indicates that financial institutions are tightening their lending standards, making it harder for businesses to access fresh capital. This could spell trouble for the growth stocks that have been driving the stock market higher.
The third-quarter Senior Loan Officer Opinion Survey on Bank Lending Practices from the Federal Reserve further supports this notion, revealing that a significant number of domestic banks are tightening their lending standards for commercial and industrial loans to medium-sized and large companies. If businesses struggle to access capital, it is likely that economic growth will weaken in the coming quarters.
While these money-based metrics do not paint a positive short-term picture for stocks, perspective is crucial on Wall Street. Short-term traders may face uncertainty, but for long-term investors, turbulence can present opportunities. Recessions and stock market corrections are normal and expected parts of the economic cycle, and they are usually short-lived. Over the past century, economic expansions have far outweighed downturns in terms of duration and optimism.
In conclusion, while certain economic indicators are signaling potential trouble for Wall Street in the short term, long-term investors can find solace in the historical resilience of the stock market. Time has consistently favored those with a long-term perspective, and despite occasional setbacks, economic expansions have proven to be more significant and enduring.
